What Is an Initial Coin Offering (ICO) and Are They Still Relevant?

March 18, 2019
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For about 18 months an ICO was quite literally a license to make your own money.

It made overnight millionaires and led to an explosion of high-profit scams and vaporware. Billions of dollars changed hands. Some entrepreneurs came up with clever ideas. Others promised software that would end want and material scarcity. Programmers and pornographers alike got into the game.

Switzerland threw its doors open. China cracked down. Russia lied. The Securities and Exchange Commission started taking this whole thing seriously.

And now the party is ending. Welcome to the wrap party for the Initial Coin Offering.

What Is an ICO?

“ICO” stands for “initial coin offering.” It is a business practice for companies in cryptocurrency and blockchain to raise startup capital. A firm will announce its intended product. Then, during early development or before development begins, the company will sell a batch of tokens to be delivered once the project launches. The company uses this as seed money to build its product and to establish a market price for its tokens once they hit the open market.

To understand how and why an ICO works, first you have to know a little bit about the brand-new industry that is blockchain.

What Is Blockchain?

Now, we won’t go into too much detail here. For a more thorough description of the technology, check out our article on cryptocurrency here. But what you do need to know is this:

Blockchain is a data storage and security format. Among its chief benefits, blockchain lets someone create records that are publicly accessible but highly secure. Basically, lots of people can read the data but only authorized individuals can make changes. Because of this, programmers who use the blockchain format can create unique digital assets.

That’s actually kind of a big deal because of…

Blockchain and Double Spending

The double spending problem is a core issue with fiat currency. You might know it as “forgery.”

Without strong protections someone can take a single dollar and make infinite copies of it. This would let them spend that same dollar over and over again, rendering it worthless because it no longer has any scarcity. Hence the term “double spending.” (A consumer would spend the same dollar twice.)

This has always been a critical problem with the online economy because every digital asset, from a hamster gif to the next Avengers movie, is prone to double spending. Anyone who can read a file can copy the file for effectively zero cost, letting them give that asset away while also keeping a fully functional copy. This is why the internet led to an explosion in piracy.

Tokens And Cryptocurrency

Blockchain has solved the digital double spending problem for now.

The architecture of blockchain lets the entire world see a given digital asset along with its owner. The security of blockchain prevents someone from making unauthorized changes to that ownership information. So you could create a file called “ABC123” and set ownership to “John Smith.” The whole world can see that file ABC123 exists and belongs to John Smith.

John Smith could make as many copies of it as he wants, but the public nature of the file prevents him from making an “ABC1234.” It would be like trying to run off supernotes at the neighborhood Kinkos. If he gives “ABC123” to Jane Doe, then every copy of that file will update to “Owner = Jane Doe.” No giving the file away and keeping it at the same time.

This led directly to the creation of blockchain tokens and cryptocurrency.

Tokens are exactly what their name suggests. They are a token that a project creates using blockchain, one which it then gives, sells or trades to users. Each one can be as simple as a database identification and an owner, like our “Token=ABC123; Owner = John Smith” example. They’re also known as “coins.”

Cryptocurrencies are a form of blockchain token. Their purpose is to be spent, saved and invested like money. Bitcoin is the most famous cryptocurrency. The Bitcoin project creates tokens (about 17.5 million of them at time of writing), and it issues them with the idea that consumers will use them as a store of value in the same way that we use dollars and euros.

Other tokens are better thought of as arcade coins. Blockchain projects will create and issue them to be used in their software for some specific purpose, like you would put arcade coins into a skee-ball machine. While these tokens may not be intended specifically as currency, people will then buy and sell them based on how valuable they find the project. These are called utility tokens.

So, for example, take a security firm. It might issue utility tokens for use in its project. Customers will buy those tokens on the open market. Then they will go into the software and use those tokens to purchase security services. People who provide those services will get paid in tokens, which they will in turn sell on the open market for spendable currency. If the firm’s software is successful people will buy enough tokens to keep the price up, making this both self-sustaining and profitable.

The Token Business Model

Oh, and the blockchain company makes money off of this too.

The market-consumer-service provider-market relationship described above is a very simplified version of what blockchain companies call the ecosystem. The goal is to run software internally off these tokens and externally funded by buying and selling these tokens on the open market.

The business model for an ecosystem supported company is to sell its own tokens. The company can create and sell new tokens over time, it can take a service fee off of each transaction or, most often, a combination of both. In all cases the company depends on the demand for its services to keep the price of its tokens relatively high so that it can, in turn, sell its own tokens on the open market.

Again, think of it like an arcade. You buy tokens and put them into the pinball machine. Except in this case you have to bargain for tokens from the other kids at school, who also work at the arcade and get paid in those selfsame tokens.

This is the point where we ask: Why not simply sell users credits and reimburse service providers based on their contributions? Why go to all the trouble of an open market? The answer is that blockchain firms are willing to risk having the price of their product crash to chase the dream of minting the next accidental Bitcoin. They’re hoping that the market will reward them disproportionately to standard retail pricing.

Giving Tokens Value Before They Have Value

So, the business model of a blockchain firm is often to make and sell tokens, which users then spend to use the company’s software. If everything goes right, those tokens will gain value over time before hitting some stable value based on supply and demand.

As a result, many people view utility tokens as an investment vehicle. They buy the tokens not to use but to speculate on. Like with any other investment they want to buy low and sell high.

This led to the ICO, the “initial coin offering.”

An ICO is one way for young blockchain companies to raise startup funds. Once the company has announced itself, typically through a website and a whitepaper, it will then announce its Initial Coin Offering. During this offering the company will sell a set number of tokens for its future project, typically at a fixed price. Buyers will receive the tokens once the project launches.

The goal for the company is to sell what amounts to zero up-front cost assets and raise the money to build its project, all without having to take on the burden of loans or split ownership with investors. The goal for investors in an ICO is, almost always, speculation. They hope to buy the tokens cheap and sell them for much more after the project launches.

So, take our security firm example above. It might announce itself through a website, whitepaper and social media campaign. Then it would announce that it is selling 10 million tokens at $10 apiece. (Typically ICO campaigns accept payment only in cryptocurrencies, but we’ll err on the side of simplicity.)

In this case the security company wants to raise $100 million in startup funding. Anyone who buys into the ICO wants to make money by selling its tokens on for more than $10 apiece. Ideally this would be based on a careful reading of the project’s technology, business plan and leadership credentials. But in reality an ICO is driven by gambling more often than not.

The Death of the ICO

Oh, and the ICO is essentially finished.

While this business model will probably survive in some different form someday, the pure initial coin offering is essentially over. This happened for two reasons.

Scams

Careful readers will have noticed a problem with the ICO business model. Unlike an initial public offering, which involves a proven company and significant oversight, the initial coin offering puts forth nothing but a series of online documents. Websites, resumes, whitepapers, even LinkedIn profiles, these can all be faked by a dedicated tweenager with a few hours to kill in between episodes of “Steven Universe.”

And, with nothing more up front, these projects ask for literally hundreds of millions of dollars in investment. Many get it.

So… it should probably surprise no one what happened next. Scammers made fake websites. They made a lot of fake website. They made so many fake websites that at one point 80% of all in-operation ICOs were scams. One single fake IPO called Pincoin stole $660 million for a project that did not exist.

Yep, for less effort than it takes to write a WordPress blog about chipmunk bowling leagues, someone out there became two-thirds of a billionaire.

There’s No Such Thing as a Utility Token

Also, the utility token doesn’t exist.

The business model of an ICO depends entirely on a lack of oversight. It is a low cost, low overhead operation designed to let a company raise a lot of money quickly and get back to work. It is also designed to let a company market its product based chiefly on ambition. At its best, this lets programmers focus on what they do best and race their competitors to market.

At its worst, well, again. Scams. So many scams.

Preventing scams, along with vaporware (companies that take investors’ money and lack the competence to see a business through), embezzlement and good old fashioned laziness, that’s why traditional rounds of investment have rigorous oversight from the Securities and Exchange Commission. Launching an IPO, where a company issues its first publicly traded securities, is a lengthy process that involves no small amount of disclosure and expense.

The expense and length of that process is why blockchain companies don’t want to go through IPOs. They claim that an initial coin offering is entirely different because utility tokens are products, not securities. Someone buys a utility token to use in a software environment, and any trading is ancillary to its core purpose. As a result, an ICO merits no oversight or regulatory action.

Nonsense, said the SEC. Investors buy these tokens as investments, consumers trade these tokens as investments and companies market these tokens as investments. They meet the elements that the SEC looks for in a security, known as the Howey Test, and will be regulated as such.

Remember above, where we asked why blockchain firms don’t just charge users a fixed fee to buy credits on their systems? It’s because these firms approach their tokens as investment products, hoping to reap the rewards of high performance.

Now, the market does continue to move and adapt. By the time you read this the ICO may have adapted and moved on. Utility tokens may have developed in a new, more useful way. However, for the time being, the ICO will remain the artifact of a digital gold rush.

A lot of people got rich off the ICO. Some of them were even actual entrepreneurs.

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